STUMP » Articles » Chicago Pension Obligation Bond Idea: It's the Discount Rate, Stupid » 27 August 2018, 22:02

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Chicago Pension Obligation Bond Idea: It's the Discount Rate, Stupid  


27 August 2018, 22:02

Ugh, I guess this thing is being trial-ballooned-out-the-wazoo. I reiterated my hatred of POBs recently, and explained why Chicago specifically is not credible in this sphere.

But it’s rolling on.

So let’s see what is being said.



“successful interest rate arbitrage”?


It gets sold or talked up as an arbitrage, but people who know what arbitrage truly means realize this is bullshit.

“We’re replacing 8% debt with 5% debt!”

Not exactly. You’re pretending the proceeds from the bonds will accrue 8% per year – your supposed arbitrage. You can’t get a guaranteed 8%, especially as you’ve got cash flows leaving to benefits along the way.

I find the “no GO downgrade” language laughable as well…that Chicago will not get a credit rating downgrade on their general obligation bonds (though I think these may be considered special revenue because they’d attach sales tax receipts).

I know when I take out the largest loan ever to refinance my largest credit card bill (to finance old operational costs, not capital costs), I expect my credit score to get whacked hard.

Then there’s the tax increases…

Basically, there are so many conditions that are unrealistic to make this “workable”. It won’t work, because it’s Chicago. They’ve not shown fiscal discipline in a very long time, and I really doubt they’ve got that discipline in place now.

Okay, that’s enough from me. Let’s switch to what other people have to say, because, since I posted on the 19th, there’s a lot more out there.


From Heather Gillers at the Wall Street Journal:

Chicago’s New Idea to Fix Its Pension Deficit: Take On More Debt

Proposed $10 billion bond would be biggest pension obligation bond ever issued by a U.S. city

Chicago tried to lower its pension deficit with budget cuts, benefit reductions and tax increases. Now the third-largest U.S. city is considering a controversial new fix: more debt.

Finance Chief Carole Brown said she would decide in the next week whether to endorse a $10 billion taxable bond offering that would be used to help close Chicago’s $28 billion pension funding gap. If the proposal is accepted by Mayor Rahm Emanuel and approved by the City Council, it would become the biggest pension obligation bond ever issued by a U.S. city.

The bet is that Chicago can earn more investing the proceeds than it paid to issue the new debt, setting an example for other large governments wrestling with sizable pension deficits. Many cities and states around the country don’t have enough assets to afford all future benefits owed to retirees. The soaring costs are squeezing budgets across the U.S.

But if Chicago’s gamble doesn’t pay off, it could end up with more debt that it can’t afford to pay. Pension obligation bonds have backfired on other cities, contributing to the chapter 9 bankruptcies of Detroit, Stockton, Calif., and San Bernardino, Calif.


More than 400 governments have issued pension obligation bonds over the past 30 years. The volume was highest in 2003, the year the state of Illinois issued a $10 billion bond—still the largest ever by any U.S. city or state government.

But that deal didn’t solve Illinois’s problems . Fifteen years later its state employee pension fund has just 35% of what it needs to afford all future benefits owed its workers. In fact, the shortfall prompted discussion this year of a new $107 billion pension obligation bond deal. That proposal hasn’t gained momentum.

No U.S. city is in a deeper pension mess than Chicago, where four pension funds have a combined shortfall of $28 billion, according to city financial records. It is in this position because of some of the same problems that tripped up other governments: decades of low government contributions, overly optimistic assumptions and overpromises on benefits. Two recessions added additional losses.

The presentation listed a 5.25% interest rate for a $10 billion bond. The debt would be taxable since the federal government typically doesn’t allow cities and states borrowing for pensions to take advantage of the tax exemption usually afforded to municipal bonds.
But even if the city were able to raise $10 billion, Ms. Brown said, that wouldn’t be enough to solve all its problems. Chicago would still have to find more money to cover all of its annual pension costs.

“If we do this we’ll still have to find additional new revenue, we would just have to find less,” Ms. Brown said.

From Sunny Oh at MarketWatch – Chicago mulls $10 billion debt sale to fill pension funding hole — here’s why it’s a bad idea

Pension obligation bonds, or POBs, have been connected with high-profile municipal defaults in California’s San Bernadino and Stockton, as well as Detroit. At the state level, issuers of POBs including New Jersey and Connecticut, and the territory of Puerto Rico, have seen a decline in their pension funding ratios and suffered downgrades to their credit rating as a result, noted analysts at Municipal Market Analytics. Illinois, in fact, issued pension bonds in 2003 that only temporarily brought up funded ratios.

Last Tuesday, the city’s Chief Financial Officer Carole Brown, citing low-but-rising interest rates, said she would make a decision yet this month on whether to recommend issuing POBs, drawing criticism from municipal finance analysts and academics.

Taking advantage of historically low interest rates, the proponents of pension obligation bonds say local and state governments can borrow at a rate less than the expected returns of their pension funds. This difference can be used to top up the unfunded pension liabilities without having to raise taxes.

But investment returns are fickle, and historically overstated. According to the National Association of State Retirement Administrators, the average public plan said it would deliver 7.56% annually as of February but the realized annual returns from 2001 to 2016 have been closer to 5.5%. Linked to the ups and downs of financial markets, public pension returns are rarely high enough on a regular basis for municipal governments to consistently exploit the difference between expected returns and borrowing costs.

And if pension funds fail to hit their return targets, the city will be saddled with both the unfunded pension liabilities and the costs of financing the new pension bond debt.

Chicago mayoral candidate Paul Vallas, who, among others, is challenging sitting mayor Rahm Emanuel in a 2019 race, said issuing pension bonds resembled “mortgaging your home and future paychecks to pay off your credit cards.” He has called for public hearings.
Sales of pension obligation debt is on the decline.

Aside from questions over their viability, a sale of pension obligation bonds could hurt the city’s fiscal flexibility. To service a looming bond payment, it could mean the city would have to cut down on social programs. With only unfunded pension liabilities on the books, the city can currently shift the timing of its regular pension contributions to avoid that dilemma.

About that… they were able to “shift the timing” for decades. They’ve already pissed away financial flexibility due to that.

Elizabeth Bauer at Forbes: Why Chicago’s Pension Obligation Bond Plan Is Even Worse Than It Seems:

Since the city’s bond ratings are below investment grade (Ba1 at Moody’s, that is, one notch below investment grade), Chicago is now resorting to an alternate method of issuing bonds, in order to avoid the very high rates they’d otherwise have to pay: this is the use of future sales tax revenue as collateral.

This means that, not only is the city mortgaging its future to try to cope with overpromised and underfunded benefits, it’s doing so in a way that traps residents far more deeply.

Chicago is not the first city to issue such bonds; again, the WSJ notes that Detroit, Stockton, and San Bernardino did so likewise, and subsequently declared bankruptcy. But pledging future sales tax revenue, in a manner that’s inescapable even in bankruptcy, in a city that’s already sold off (sorry, 100/75-year-leased) future Skyway toll road revenues and future parking meter revenues, to plug municipal budget holes — that makes the proposal far more worrisome than even the market risk of a conventional pension obligation bond.

From ALEC: Chicago Pension Obligation Bonds, a Strategy or Gamble? – American Legislative Exchange Council

Chicago Mayor Rahm Emanuel’s administration is exploring the possibility of issuing billions of dollars of pension obligation bonds and investing the proceeds in order to reduce the city’s $28 billion in official net public pension liabilities. If the investment returns exceed the borrowing costs, the annual pension funding cost to Chicago taxpayers will be reduced, diminishing the need for tax hikes to resolve the problem. However, if the return on the invested bond proceeds falls below the interest rate on the pension obligation bond series, the existing pension liabilities will grow even larger, leaving Chicago taxpayers worse off. With interest rates on the rise and equities markets that have already realized long-term gains, the latter outcome of this arbitrage gamble appears increasingly likely.

The success or failure of a pension obligation bond is largely dependent on timing. Ideally, a pension obligation bond is issued during the intersection of historically low interest rates and the recovery period after a recession. The time between these windows of opportunity can span a decade or more whereas political considerations rarely extend beyond the next election. For politicians, a pension obligation bond may provide a solution to a cash flow problem; but these bonds are rarely suited to be part of a comprehensive liability management strategy. Indeed, most pension obligation bonds have been issued out of desperation.

There’s a reason a bunch of different people keep hitting on the same points.

It’s never the places that have handled their finances well that issue POBs.

I know Alicia Munnell et. al. have said that theoretically POBs can be good, but it is contingent on a bunch of behaviors that most POB issuers have not been following for decades. It’s like saying subprime mortgages have great features for prime borrowers.

Isn’t that a great catch, that Catch-22?

Here are some other (mainly negative) remarks:

So in the above, only one link has people being positive about the POB idea… with a hell of a lot of caveats.


Some Chicago aldermen leery of Mayor Rahm Emanuel’s possible $10 billion pension borrowing plan – Chicago Tribune

Chicago Mayor Rahm Emanuel’s financial team will soon decide whether to recommend the city borrow billions to shore up its ailing public pension funds — a move some experts call risky but that Emanuel allies maintain could save taxpayers money and ease the pain from future pension-related tax increases.

City Chief Financial Officer Carole Brown said she could give Emanuel her recommendation by the end of the month or early September. The city might end up borrowing more than $10 billion, depending on the details, she said.

But Brown countered criticism from some, including mayoral challenger Paul Vallas, that the plan is being fast-tracked toward approval, saying she has not yet decided on the plan.

Brown’s PowerPoint presentation said the bonds would “provide significant reduction in cost of pension debt,” “materially improve the funded status of the pension funds” and “decrease the total amount of additional revenue required to fund pensions, saving billions for Chicago taxpayers.”

The plan “will not” add “additional reinvestment risk,” the PowerPoint said.

But that isn’t entirely true, as there’s risk that with another major economic downturn, the pension funds could lose a substantial amount of their invested money. Then the city could end up on the hook for both bigger contributions to the city’s four pension funds and the interest on the pension bond debt.

Interesting. This is supposed to be a “straight” news article. And it’s pointed out that a Powerpoint deck is lying! (In weasel words: “isn’t entirely true” means “lying”)

Now, I’m gonna take the Powerpoint presentation’s point of view, and agree — there will be no additional reinvestment risk.

There is an additional liabilitiy – you’ve got the pensions (as before) and a bond debt (new liability). So two debts in place of one.

But the risk is not reinvestment risk, you see. It’s “not having enough money” risk.

Sorry if I got too actuarial on you.

But let’s see what the alderpeople say:

Ald. Scott Waguespack, 32nd, a frequent Emanuel critic, said Brown did little to convince him Thursday that the mayor’s administration would adequately address aldermen’s lingering concerns that the bond plan would put the city at risk before asking them to vote on it.

“We were trying to press her on different scenarios, like what would happen if the market fell, or the housing market took a big hit, and she said she could play around with a few different things but she didn’t have anything specific for us (at the briefing),” Waguespack said.

“So we said to her, ‘Well, when are you looking to move forward?’ and she said ‘late August,’ ” Waguespack said. “And we said, ‘It is late August.’ She then said, ‘Oh, I mean early September,’ and we said, ‘What?’ ”

Longtime Ald. Joe Moore, 49th, a reliable Emanuel ally, said city officials “understand that they are working under a microscope and they’re going to have to justify” any recommendation. He said any proposed plan needs to be “done right and thoughtfully.”

“We have to do it with the point of view of not kicking the can down the road and making the situation worse for future generations,” he said. “This has to be something that is a calculated and well-thought-out measure and not a risky scheme.”

Ald. Daniel Solis, 25th, another veteran alderman and mayoral ally, said he needs more specifics before deciding whether he supports the idea. But facing the likelihood of post-election tax hikes to cover additional pension debt, Solis said the bond proposal is one way to potentially ease that pain for residents still smarting from Emanuel’s recent spate of massive tax and fee increases.

“If anybody comes up with another idea — like some of the aldermen (in the briefing) were having a lot of questions, I wouldn’t say criticizing it, they had a lot of questions. I said, ‘But does anybody have any other ideas right now?’ ” Solis said. “(The answer) was no.”

Retiring Ald. Ricardo Munoz, 22nd, who is an occasional Emanuel critic, said he supports the borrowing plan.

“Anything to shore up the pensions is a good idea,” Munoz said.

I will get back to the “shore up the pensions” in the next subsection.

But here is another piece with the same message of skepticism: Aldermen ‘lukewarm’ as they are briefed that pension borrowing could top $10B | Chicago Sun-Times


There’s a big ball of bad ideas with the POB. First, it’s only $10 billion out of a $28 billion putative shortfall.

I like to use fancy words, so let me point out the definition of putative:

Generally regarded as such; supposed

So, why is it supposed that the pension fund shortfall is $28 billion, and no more, no less?

Because of official accounting standards. Where the funds get to dictate what interest rate things are discounted at… except that changed a bit relatively recently.

Someone reminded me recently about the new public pension accounting standards, where that assumed discount rate gets tuned down to something lower… if projections showing the assets running out. At which point, future cash flows are assumed to be discounted at municipal borrowing rates… which are a lot lower than the 7%-8%. (indeed, that’s the idea behind POB “arbitrage”)

The way most do this is not to actually discount the cash flows at two different interest rates, but use a single “blended” rate. So it’s a kind of weighted average of the assumed return on assets and the muni bond rate.

Check out this post from John Bury on the state of the Chicago pensions:

Two years ago we did a study of the Chicago plans based on data from actuarial reports. Updating we find benefits and liabilities increasing, funded ratios declining, while deposits and asset values remaining constant and therein lies the reason for this Pension Obligation Bond (POB).

With negative cash flow of $1.3 billion it has been outsized investment returns that have kept the plans from total collapse. The question is whether those investment gains were bought at the price of illiquidity that now requires an influx of very liquid bond money to keep making those $3.5 billion (and rising) payouts?

Another question is that, from the charts below, it looks like the Teachers plan and possibly the Laborers’ with their 49% funded ratios may not get any POB money as the headline underfunded amount being thrown out there is $28 billion which is the total for those other three plans with funded ratios in the 25% neighborhood.

And I took a quick look at the reports linked by Bury.

Here are the blended discount rates, by fiscal year:
Laborers: 7.07% (2017)
Municipal: 7.0% (2017), 3.9% (2016)
Teachers: 7.07% (2017), 7.75%(2016)
Police: 7.00% (2017), 7.07% (2016)
Fire: 7.23% (2017), 7.30% (2016)

I didn’t have the 2016 number for the Laborers’ plan. But I want to point out a huge change:

MEABF went from 3.9% rate in 2016 (as it was running out of money rapidly) to 7.0% in 2017. What happened?

Here’s the official language: (page 47)

For December 31, 2017, the discount rate used to measure the total pension liability was 7.0%. The projection of cash flows used to determine the discount rate assumed plan member contributions will be made according to the contribution rate applicable for each member’s tier and that employer contributions will be made as specified by Public Act 100-0023. For this purpose, only employer contributions that are intended to fund benefits of current plan members and their beneficiaries are included. Projected employer contributions and contributions from future plan members that are intended to fund the service cost of future plan members and their beneficiaries are not included. Based on those assumptions, the pension plan’s fiduciary net position was projected to be available to make all projected future benefit payments of current plan members. Therefore, the long-term expected rate of return on pension plan investments was applied to all periods of projected benefit payments to determine total pension liability.

For December 31, 2016 the discount rate used to measure the total pension liability was 3.9%. The projection of cash flows used to determine the discount rate assumed plan member contributions would be made at the current contribution rate and that employer contributions would be made at the 1.25 multiple of member contributions from two years prior. For this purpose, only employer contributions that are intended to fund benefits of current plan members and their beneficiaries are included. Projected employer contributions and contributions from future plan members that are intended to fund the service cost of future plan members and their beneficiaries are not included Based on those assumptions, the pension plan’s fiduciary net position was not projected to be available to make all projected future benefit payments of current plan members. The projected benefit payments through 2023 were discounted at the expected long term rate return. Starting in 2024 the projected benefit payments were discounted at the municipal bond rate. Therefore, a single equivalent, blended discount rate of 3.9% was calculated using the longterm expected rate of return and the municipal bond index.

Here’s the simple language: they had an assumed rate of return on assets of 7%.

For fiscal year 2016, the assumption of future contributions was such that the assets ran out in 2023, and thus the overall liability cash flow was weighted at almost exactly the muni borrowing rate.

For fiscal year 2017, a deal had been done, and they could pretend that all future contributions would be sufficient such that the assets wouldn’t run out… so they got to use the assumed rate of return on assets of 7%

The difference ended up being a $7 billion reduction in the pension liability between 2016 and 2017.

So you see why a POB might be extremely important right now? It’s only $10 billion being floated because the largest POB in the past was from the state of Illinois, and that was $10 billion.

But if the POB doesn’t go through, those blended valuation rates are likely to keep going down, with a rising liability valuation.

This is accounting-driven, because it sure as hell doesn’t reduce the risk in the system.


Short note: my blogging is not regular – the blog is a hobby, and it’s not my highest priority. I do have themes I like to hit on particular days, but that’s just because I like alliteration.

You can always read my livejournal, which I update even more infrequently, but if I’m having health issues, that’s where I write about it. My most recent such post. But I have happier reasons for not posting this past weekend:

The FDR Home, Museum, and Library (and these are two separate things, one run by the National Archives and the other by the National Park Service) is a great site, and I think the presentation was very fair. I will definitely be going back, because it’s in an awesome location, (also: I highly recommend the Eveready Diner in Hyde Park, where we had lunch), it’s chock full of stuff I barely perused, and I want to go to the Vanderbilt house and to Val-kill, Eleanor Roosevelt’s house. (And yes, they get into how/why ER had this set up).

You’re always welcome to email me: or tweet at me (@meepbobeep), though I may not respond.

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